What Is Working Capital?
It reflects a company’s ability to meet its short-term obligations relating to day-to day operations of the company using its Operating current assets. Working capital is the difference between current assets and current liabilities of a company.
In the calculation of working capital, there are certain items under current assets and current liabilities that are to excluded. I shall be explaining what are the exclusions and the reason why it is excluded.
So, what are Operating current assets?
Operating current assets are the short-term assets directly related to a company's core business operations and they are liquid enough ie expected to be used or converted into cash within one year or one operating cycle(w.i.l), to meet the operational liabilities.
Exclusions from Current assets:
So, to calculate the Operating current assets from total current assets, following the adjustments that needs to be done.
- Prepaid expenses: These are payments towards expenses made in advance. Does not represent cash that can be utilised towards settlement of dues. Hence excluded.
- Advance tax and deferred tax assets: Advance tax represents advance payment to Statutory authorities. Doesn't represent a potential cash flow generating current asset and not hence not usable for settling short-term obligations.
- Non-operational investments: Short-term investments may be in the form of short-term marketable securities invsted for speculation or surplus cash parking and are unrelated to core business and hence may be excluded.
- Assets held for sale: These are intended for disposal. Not available for settling current obligations of the business.
What if these continue to be included?
Not excluding these items can inflate current assets and give a misleading picture of liquidity to analysts and investors who want to know about the capacity of the company to meet short-term obligations. Misleading in the sense, as if there is sufficient truly available resourcesto meet the current liabilities. But reality may not be that greeny!
So, what are Operating current liabilities?
The basic purpose of Working capital assessemnt itself is to assesses a company's ability to cover day-to-day expenses and maintain smooth operations. Therefore, liabilities directly tied to the operating cycle – the process of converting raw materials to cash – are the most relevant one for the purpose. Those liabilities are also referred to as operating liabilities.
Exclusions from Current Liabilities:
So, to calculate the Operating liabilities from total current liabilities, following the adjustments that needs to be done.
- Unclaimed Dividend : Dividends due on shares are generally excluded because these are obligations to shareholders, not operating liabilities related to the running of the business.
- Customer advance: Barring exceptional circumstance of refund which is remote, Customer advance is not a liability requiring cash outflow. It represents future service obligation.
- Non-operating current liabilities like short term borrowings, current portion of long term debt etc are related to financing activities (financing liabilities) and are distinct from liabilities that arise from company's daily operations. Hence like including them would distort the picture of a company's day-to-day operational liquidity.
- short-term provisions short term provisions relating to non-operational items/activities are excluded.
What if these continue to be included?
Including these items can distort liquidity ratios because they dont necessarily require immediate cash settlement. For our WC purpose, analysts focus only on liabilities that demand near-term payment using operating current assets.
🧐 Thought For Conceptual Understanding:
Question:
Can accounts receivable and inventory can realistically be converted to cash within a year, as this is crucial for their inclusion in working capital calculations?
Answer:
Accounts receivable and inventory are generally considered realizable within a year in most industries. Rationale behind including them as current assets is :
- Debtors:
- Inventory:
Most businesses operate on credit terms, extending credit period of 30-90 days to pay, after receiving the invoice.
On an average, companies take 45 days to collect its receivables. (ACP) . Manufacturing or construction industry have a comparatively higher ACP of 45-90 days and retail have ACP of 30-45 days.
With good credit and collection policies and collection efforts of AR staff, companies try to keep it under 45 days.
Cash Conversion Cycle (CCC) of the company measures the time it takes to convert raw materials into cash from sales.
CCC = Includes the time inventory sits in storage (DIO) + time it takes to collect cash from customers (DSO) - the time company takes to pay suppliers (DPO)
The CCC of companies varies by industry, but at an average, it's between 30 and 45 days.
Inventory techniques like inventory forecasting, managing supply chains and setting optimal reorder points can play vital role in shortening the time inventory sits unsold and enhance realization.
The above data on payment terms for accounts receivable, average collection periods (ACP) and the overall Cash Conversion Cycle (CCC) collectively demonstrate that both debtors and inventory are generally converted into cash well within a year.